Tuesday, March 23, 2010

[JPMorgan Chase CEO Jamie] Dimon was castigated by many people, me included, for saying that a financial crisis is “the type of thing that happens every five, ten, seven, years.” Hey, no big deal.

But that is the way banking worked once upon a time. I’m reading Gary Gorton’s Slapped by the Invisible Hand, which tells us that there were bank panics — systemic crises — in 1873, 1884, 1890, 1893, 1896, 1907, and 1914.

On the other hand, there were no systemic crises from 1934 to 2007.

The problem, as Gorton makes clear, is that the Quiet Period reflected a combination of deposit insurance and strong regulation — undermined by the rise of shadow banking. So we have a choice: restore effective regulation or go back to the bad old days.

(emphasis added)

First of all, the emphasized phrase is flatly untrue, and a distortion of what Dimon said. Financial crises are not limited to banking crises, and nobody but Krugman thinks that. Kindleberger, Eichengreen, Bordo, Reinhart & Rogoff... all notable economic historians of financial crises think of banking crises as being just one type of financial crisis.

Second, it wasn't just the 19th century: regular (every 7 years or so) financial crises go back centuries. Not in every jurisdiction, of course, but that matters less and less in a world where financial markets are highly globalized.

Third, there were so financial crises in between 1937 and 2007! Banking crises even! In America! Has Krugman forgotten about the 1980s Latin American debt crisis that would have sunk the American banking sector were it not for U.S. government intervention (through the IMF) in providing funding to Latin American governments? Has Krugman forgotten about the Savings and Loan crisis in the 1980s that led to the collapse of 747 S&Ls, the early-90s recession, and massive government intervention into financial markets? Has Krugman forgotten about the 1994 Tequila crisis that threatened American banks holding Mexican bonds, requiring a $50bn intervention by the U.S., IMF, BIS, and Canada? How about the LTCM collapse in 1998 that led to counterparty risk that threatened the solvency of every major bank on Wall St., thus requiring U.S. government intervention?

There. There's 4 systemic banking crises that necessitated U.S. government intervention within a 15 year period, and I left out a number of borderline cases (the Herstatt collapse in the mid-1970s, the dot-com collapse, or any crashes in any other countries that could have had or did have knock-on effects for U.S. financial institutions). Were they all as bad as the Great Depression or the subprime mortgage crisis? No, but that's not at all what Dimon was saying.

Why does this matter? Because Krugman has supreme faith that if we just add some (unspecified) regulations then we'll go back to the Quiet Days. But the Quiet Days correspond almost exclusively with the Bretton Woods system of fixed exchange rates, which wasn't entirely quiet in truth, and was unsustainable for other macroeconomic and political reasons. The collapse of Bretton Woods led to -- you guessed it -- the systemic economic decline of the 1970s. So even if we could go back, it wouldn't be Quiet Days, and it wouldn't last.

Following Krugman's advice could lull us into a false sense of security that "this time is different" when it really isn't. This is dangerous. Dimon is right: these things happen with alarming regularity all over the world, and they have done so for centuries. If we think we've escaped the pattern we're likely fooling ourselves. We do need to reform our regulatory structure, but we need to do so in a way that can facilitate crisis response, not merely crisis prevention.

UPDATE: Double-D @ Crooked Timber says basically the same thing as me, except he (for some reason) thinks that it isn't important:

If we’re going to include things like the First Baring Crisis and the Panic of 1893 (which were big news at the time, but by no means earth-shattering), then I can give you a list. Even using a selective criterion of only crises with significant US involvement (ruling out the Nordic, French, Spanish and Japanese banking crises), we have the following list …

As far as I can see, things were pretty stable between 1934 and 1970 (give or take the odd war), but that in the era of floating exchange rates it’s been very unusual to go seven years without a crisis and the modal gap looks closer to three years than four.